Wednesday, September 29, 2010

Citigroup put out a note last week arguing that Equinix (EQIX) should consider becoming a REIT in order to close a gap in its market value relative to Digital Realty (DLR) and DuPont Fabros (DFT). This would be a terrible idea though for the collocation provider. Co-lo and data center REITs remain very separate businesses, with different operating and financial requirements, and in many respects they're growing further apart.

The primary financial difference between providing co-lo space and building space is the number of people a provider has to pay. DLR generates over $2 million dollars in revenue per employee, Equinix just $600,000. DLR, DFT, and COR, like most REITs, need to generate NOI (net operating income) margins of about 65% to justify the high cash flow/high dividend strategy needed for that form of business. While less hands-on than managed services, which often entail a lot of software configuration, co-location is not a real estate business. It requires far more internal experts in areas like database management, network technology, and industry-specific sales support than a typical data center REIT has on staff. The additional staffing needed to do this in the co-lo business eats into operating margins, and makes it financially unsuitable for the REIT structure.

A co-lo provider needs to generate more revenue per dollar invested in fixed assets than a REIT to offset the higher staffing requirements. Equinix has been producing about 40 cents of revenue per dollar invested in PP&E compared to around 20 cents for DLR and DFT. Essentially, co-lo is more labor-intensive, less capital-intensive than the data center REIT business, which makes mixing the two very difficult.

It's easy to look at stock valuations and rush to judgments about quick fixes that could temporarily lift the price. But the trend is for co-location providers to lease space from REITs, as Telx is doing with DLR. Perhaps sometime in the future when it slows down its expansion, Equinix could consider paying some kind of dividend, but bringing its productivity and fixed asset ratios into line for a higher yielding REIT would require destroying existing operations, which would cause a lot more problems for the stock than its current valuation gap.